Research coverage for an issuer is an essential element of investor relations for gaining market awareness and exposure, increasing potential investment by removing uncertainty through information dissemination and improving stock trading liquidity, which has the effect of reducing risk for investors.
But there is a dearth of traditional full-service broker-dealer research coverage for small-cap companies – especially micro-cap companies, which are quite often led by the trailblazing entrepreneurs our society needs to bring new innovations and unique products and solutions to market. It’s no wonder smaller issuers must consider the benefits of employing issuer-paid research.
There is a common misconception, however, that when research is paid for by the issuer, this creates a bias in a research analyst’s coverage toward a positive recommendation that would not otherwise be there with traditional research. This could not be further from the truth.
The following is a representative disclaimer typically found on traditional broker-dealer research reports: ‘Our banking division may do business or seek to do business with issuers covered by our research division; therefore, a conflict of interest could affect the objectivity of reports and recommendations on issuers covered by our research. Investors should be mindful that a conflict of interest may exist, and that they should seek other sources of information and advice to make a fully informed investment decision rather than relying solely on our reports.’
‘Cross-division business expectations’
Out of thousands of recommendations tracked by market data provider FactSet for S&P 500 companies, only about 6 percent are sell ratings, reports CNBC.
Full-service broker-dealer research divisions do not get paid by the issuer to have a report written about the company, unlike issuer-paid independent research. They make money primarily through writing research that drives trading volume through their trading business, or investment banking business when their investment banking division is involved in raising capital or providing M&A or other capital markets advisory services.
There is still a tacit understanding in the industry for cross-division business expectations despite there being regulation and organizational Chinese walls between divisions. Even without an introduction inside the investment firm from one division to another, if a company being covered by the research division does not include that same firm’s investment banking division in a fund-raising round, the likelihood of that research coverage continuing greatly diminishes.
So whether or not research is paid for by the issuer, the misperception that issuer-paid research inherently attracts a greater conflict of interest than the traditional approach is a misnomer. In fact, if payment is made upfront before research begins, the issuer is not bound as it may be by an investment firm to meet expectations of doing cross-division business at the firm. This can free the issuer to make unfettered decisions on its investment banking choices that could lead to better capital market outcomes for the issuer.